Flying too high with Buffett

ft.com

I once hitched a ride on a Gulfstream jet (purely for research purposes, obviously) and enjoyed the experience of being flown in a leather-trimmed cabin at nearly 50,000 feet, escaping the turbulence buffeting the commercial aircraft far below. It felt as if I had joined the elite group that lives by different rules to ordinary folk.

That too-brief flight in a NetJets aircraft is the only psychological explanation I can think of for the ethical blind spot of David Sokol, NetJets' chairman, who resigned from Warren Buffett's Berkshire Hathaway last week after mixing up his own investments with those of his employer. Sokol still does not appear to think he did anything wrong, which makes me think he has been flying too high.

Sokol is not the only one to blame for his purchase of Lubrizol shares before Berkshire Hathaway bought the chemicals company last month, netting him a $3 million personal gain. Buffett used to own a jet called The Indefensible (although he travels on NetJets these days) and that is an apt description of Berkshire's top-level corporate governance. Sokol's blunder ought to make 80-year-old Buffett address his own failure.

Buffett provided a pre-emptive judgment on Sokol's behaviour last year in a memo to Berkshire's managers and directors, including Sokol. "If you see anything whose propriety or legality causes you to hesitate, give me a call,” he wrote. "If it's questionable whether some action is close to the line, just assume it is outside and forget it.”

That is clearer than the mealy-mouthed half-defence of Sokol offered by Buffett in the statement announcing his departure. "Neither Dave nor I feel his Lubrizol purchases were in any way unlawful. He has told me that they were not a factor in his decision to resign.” Not unlawful? When Buffett fails to mention ethics, something is up.

There is no question that what Sokol did was unwise, whether or not it was insider trading under US law. He started to buy Lubrizol shares himself the day after meeting a group of Citigroup bankers who recommended Berkshire acquire the company, which it later did. Sokol says he was already thinking of buying Lubrizol shares, had no inside information and mentioned his stake in passing to Buffett, but that is a thin defence.

Even if Sokol could not be sure that Buffett would later follow his advice to consider buying Lubrizol, he was still tangling up his affairs with those of Berkshire in an improper manner. Personal trading in the shares of potential targets is unambiguously barred at Wall Street banks, which are not exactly ivory towers when it comes to financial conflicts of interest.

Sokol was allowed to get away with it by what one might politely call a "light touch” approach to oversight at the top of Berkshire. It has no compliance department to oversee the personal investments of the 20 or so employees who support Buffett in Omaha, Nebraska. "There is no infrastructure at all. There is a culture of trust,” says Alice Schroeder, author of The Snowball, a Buffett biography.

Buffett and Charlie Munger, his sidekick, instead operate like the Beverly Hillbillies of global finance, dispensing folksy wisdom (a lot of which is genuinely wise) and striking deals with handshakes. "Our trust is in people rather than process. A 'hire well, manage little' code suits both [the heads of its operating businesses] and me,” Buffett wrote in his 2010 letter to Berkshire shareholders.

This may sound like an odd way to run a railroad, but it has proved very effective as a style of running Burlington Northern Santa Fe, the railway operator Berkshire bought in 2009, as well as insurers, energy companies and others. All of these units have their own managements and risk controls.

On top of them, however, sits a patriarchal hedge fund that has for years been allowed by shareholders to get away with dubious corporate governance practices. Not only does Berkshire have a dual class share structure giving voting control to Buffett, who owns 34 per cent of the equity, but until a decade ago its board of directors was a seven-person affair packed with insiders such as Buffett's son Howard.

The board has since become more independent, but it does not say much that the member most likely to become its first lead independent director is Bill Gates, a close friend of Buffett's, his co-investor in the Gates Foundation, and his regular partner at the bridge table.

It is impossible to quibble with Buffett's record as an investor, but his record of judging whom to admit to his inner circle at the helm of the company – and the latitude they are permitted – is less salutary. Munger's family held a 3 per cent stake in BYD, the Chinese electric battery maker, before Berkshire bought a stake in 2008.

This mattered less as long as the Berkshire inner circle behaved itself and Buffett had decades to run in his job but it definitely matters now. Sokol, after all, was not just anyone – Buffett had probably put his name in the envelope to succeed him on his death as head of Berkshire's operations.

The debacle does not require a vast bureaucracy to be imposed on Berkshire but the board needs to demonstrate its independence by eliminating conflicts of interest and making its own review of senior appointments. We would all like to fly high enough to avoid such restrictions and disciplines, but it isn't always good for us.

Copyright The Financial Times Limited 2011